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Last week we wrote that the Fed's new found concern about inflation (as evidenced in their latest FOMC missive) should be taken into the perspective which history offers about the Fed's ability to accurately identify critical macroeconomic trends. Specifically, we argued that the Fed's actions in late 1999 and early 2000 (that is until their final May 2000 rate increase) speak to their inability to gauge what risks are truly being formed in the economy.

Based on the following statement from the Fed (May 2000) "the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."...

We said:

"Should we be concerned about inflation all of a sudden because the Fed is now 'concerned'? Well, given their track record - of being worried about precisely the wrong thing at the wrong time and evidenced by their 1H:2000 missives - I should say not. This is yet another reason to be worried about deflation - because the Fed apparently isn't."

We bring this up not to belabor the point about deflation but rather to speak to the general idea among strategists, investors, and economists that the Fed is immune to mistakes, is immune to the type of behavioral and psychological influences that govern many of the collective behaviors at work every day in asset markets.

You already know from our past writings that we believe that markets are a mix of both rational and irrational behaviors, with the irrational behaviors playing a very large and important role in the price discovery mechanism for any negotiated financial instrument. This is what accounts for the fact that investors - as a class - largely buy high and sell low; they are not, on average, rational. (We frequently point to the work of Tversky and Kahneman to provide the research data for this idea.)

Why, we wonder, would investors who ordinarily would accept this thesis continue to believe that the Fed is some sort of omnipotent (and benign) director of the markets? Perhaps one of the reasons is the 'oracle' aspect of the Fed we highlighted last week. But ultimately the whys are not that important.

What is important is understanding that the Fed has largely been wrong about the direction of major macroeconomic indicators (as their excessive worry about inflation in 2000 nicely illustrates). We have stated before that the bond market price record going back 25 years shows unequivocally that the Fed follows the bond market in setting their rates. If the bond market lowers rates, the Fed does too, anywhere from 1-6 months after the move by the market. The record is quite clear on this.

So how do we square this particular circle: that the Fed follows the bond market in setting rates and has just as bad a record at limning macroeconomic data series as any sell-side economist yet investors cling to the notion that the Fed is somehow 'guiding' the economy with their words and interest rate actions?

Let's call it the Reamer Theory of the Fed. Within the guiding framework of the markets as complex systems, I believe the Federal Reserve is merely just another actor, albeit a large and influential one. "Just another actor' insofar as they too fully embrace macroeconomic trends ('inflation', 'deflation', etc.) just as those trends are maturing and ready to reverse in earnest. "Just another actor" insofar as they too have little true insight into the economy or markets, despite the fact that they might have access to information sooner than other participants. Where they do remain unique however is on two fronts: (1) their ability to print money and (2) their ability to act as powerful influencers on collective psychology (economists would call this 'time preferences').

In the end however, and this is the central point I am trying to make: the Fed's willingness to use those two unique attributes is still very much tempered by the macroscopic animus - the collective behavior of the markets (again - largely irrational). To the extent the rest of the market wants to reduce their time preferences and thereby generate goods, services, and asset inflation (as we have seen from 2002 lows to now), the Fed will follow. They will run the printing press, they will 'talk up' reflation (and conversely talk down deflation). However, to the extent that the rest of the market increases their time preferences and thereby generates goods, services, and asset deflation (as I suggest we are just starting to see now), the Fed will follow too, deciding NOT to employ their printing press, deciding NOT to employ their verbal influence.

One of the central tenets of traditional 'Fed theory' is that the Fed will do everything in its power to fight deflation - the infamous showers of dollars from helicopters idea - thereby create the hyperinflation that so many gold bugs are counting on to increase the value of their gold holdings. Do I believe that hyperinflation will eventually take place? You bet. And that hyperinflation will benefit the price of gold in a massive way. But it is the underlying collective behavioral forces at work that change people's time preferences, not some group of government employed economists who by any consistent reading of the historical record are impotent in correctly predicting economic trends. And those underlying psychological forces are saying 'deflation' right now, not inflation. Once deflation runs its course (and you can expect the Fed, true to form, to be late in embracing this trend as well), inflation - hyperinflation in my opinion - will run its own course, benefiting precious metals and resources concerns of all stripes.

I believe this 'Reamer Theory of the Fed' makes sense both with the empirical data we see (the Fed following the bond market's lead and usually embracing the wrong macro trend at the wrong time) and the complexity theory dynamics (irrational crowd behavior being a defining force) that I have suggested are active in financial markets.

A good test of this theory is underway this year: if the forces of deflation are indeed gathering as my models suggest, then it won't be too long before the Fed recognizes this, starts increasing their own time preferences, and begins to embrace the deflationary trend themselves.

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